Why the F Wall Street Model is Wrong (but Nearly Right).

4042010

First of all, I criticize the F Wall Street model not because it’s terrible, but because it’s so close to being correct. F Wall Street is by far the best resource for the intelligent investor. The book is not perfect either, but I think it’s the greatest investment book I’ve ever read (the arbitrage/workouts section is priceless).

The F Wall Street model:

The model is a traditional two stage discounted cash flow model. The first stage is ten years long, and the growth rate is decided according to an analysis of the company. The second stage is another ten years at a five percent growth rate. Now, the point where this model diverges from my own is at the following instance: After discounting twenty years of cash flows, Joe adds the equity of the company to the final calculated value. In my model, instead of shareholder’s equity, I add the discounted value of the 20th year cash flow projected out to infinity at a zero percent growth rate.

Why Joe’s Model is a Little Screwy:

In a comment on his blog, I explained to Joe the following:

“Your valuation method produces strange results. For instance, a business with $1 million dollars in equity, earning a 1% rate of return is worth more than $1 million dollars [according to the F Wall Street model]. In reality, $1 million dollars worth of equity earning a below market rate of return is worth less than $1 million dollars. Similarly, a bond earning 1% on principle is going to decrease in value when interest rates rise to 5%.”

Joe responded with the following:

“The valuation method assumes that you are buying a good business and that you would skip the above business altogether. The equity is added as a “terminal value” instead of projecting cash flows out to infinity, and assumes that the equity would grow at a satisfactory rate over time. If the business has bad economics, the F Wall Street method of buying good businesses at cheap prices won’t work.”

While I see his point, why bother with a method that’s not consistent with the theory behind value investing? It’s merely a coincidence that the equity value is usually about equal to the discounted value of infinitely projected cash flows. Since Joe’s method diverges from theory, it necessarily has problems in practice. It over values companies earning a poor return on equity and undervalues companies earning a great return on equity. I’ve explained an instance of the former and I will explain an instance of the latter in the next post.